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For business owners who pay taxes in the United States, captive insurance companies reduce taxes, build wealth, and improve insurance coverage. A captive insurance company (CIC) is similar to any other insurance company in many ways. It is referred to as a “captive” because it generally provides insurance to one or more associated operating companies. With captive insurance, the premiums paid by a company are kept in the same “economic family” rather than being paid to an outsider.
Two important tax benefits enable a structure incorporating a CIC to accumulate wealth efficiently: (1) insurance premiums paid by a company to the CIC are tax deductible; and (2) pursuant to IRC § 831(b), the CIC will receive up to US$1.2 million in annual award payments exempt from income tax. In other words, a business owner can shift taxable income from an operating business to the tax-deferred captive insurer. An 831(b) CIC pays taxes only on income from its investments. IRC §243 ‘deduction of dividends received’ provides additional tax efficiencies for dividends received from its company stock investments.
About 60 years ago, the first captive insurance companies were formed by large corporations to provide insurance that was either too expensive or unavailable in the conventional insurance market.
Over the years, a combination of US tax laws, court cases, and IRS rulings have clearly defined the steps and procedures required for the establishment and operation of a CIC by one or more business owners or professionals.
To qualify as an insurance company for tax purposes, a captive insurance company must meet the “risk shifting” and “risk diversification” requirements. This is easily accomplished through routine CIC planning. The insurance of a CIC must really be an insurance, ie a real damage risk must be shifted from the premium-paying operative business to the CIC, which insures the risk.
In addition to the tax benefits, key benefits of a CIC include increased control and increased flexibility, which improve insurance coverage and reduce costs. With conventional insurance, an outside carrier typically dictates all aspects of a policy. Certain risks are often not conventionally insurable or can only be insured at an unaffordable price. Traditional insurance rates are often volatile and unpredictable, and traditional insurers tend to deny valid claims by overdoing petty formalities. While business insurance premiums are generally deductible, once paid to a traditional outside insurer, they are lost forever.
A captive insurance company efficiently insures risks in a variety of ways, such as: B. through tailor-made insurance policies, favorable “wholesale” rates from reinsurers and pooled risk. Captive companies are well suited to insuring risks that would otherwise be uninsurable. Most companies have traditional ‘retail’ insurance policies for obvious risks, but remain exposed to numerous other risks and are subject to damage and loss (ie they ‘insure’ these risks themselves). A captive company can tailor policies to a company’s specific insurance needs and negotiate directly with reinsurers. A CIC is particularly well suited to issuing business casualty policies, ie policies that cover business losses claimed by a company and do not involve third party plaintiffs. For example, a business can insure against losses caused by business interruptions due to weather, work problems, or computer failures.
As noted above, an 831(b) CIC is exempt from tax on up to $1.2 million in premium income annually. As a practical matter, a CIC makes good business sense when its annual premium income is approximately $300,000 or more. In addition, a company’s total insurance premium payments should not exceed 10 percent of its annual revenue. A group of companies or professionals with similar or homogeneous risks may form a multi-parent (or group company) captive insurance company and/or join a Risk Retention Group (RRG) to pool resources and risks.
A captive insurance company is a separate entity with its own identity, administration, finance, and capitalization requirements. It is organized as an insurance company and has procedures and staff in place to administer insurance policies and claims. An initial feasibility study of a company, its finances and its risks will determine whether a CIC is appropriate for a particular economic family. An actuarial report identifies suitable insurance policies, corresponding premium levels and capitalization requirements. After selecting an appropriate jurisdiction, the application for an insurance license can proceed. Fortunately, competent service providers have developed “turnkey” solutions for the initial assessment, licensing and ongoing administration of captive insurance companies. The annual cost of such turnkey services is typically around $50,000-$150,000, which is high but easily offset by reduced taxes and increased investment growth.
A captive insurance company may be incorporated under the laws of any one of several offshore jurisdictions or in a domestic jurisdiction (ie, in any one of 39 US states). Some captives, such as B. a Risk Retention Group (RRG), must be licensed domestically. In general, offshore jurisdictions are more accommodating than domestic insurance regulators. As a practical matter, most offshore CICs owned by a US taxpayer elect to be treated as domestic corporations for federal tax purposes under IRC § 953(d). However, an offshore CIC avoids state income taxes. The costs of licensing and administering an offshore CIC are comparable to or less than domestic. More importantly, an offshore company offers better asset protection options than a domestic company. For example, an offshore irrevocable trust that owns a captive offshore insurance company provides asset protection from corporate creditors, the founder and other beneficiaries, while allowing the founder to enjoy the benefits of the trust.
For US business owners who pay significant insurance premiums each year, a captive insurance company efficiently reduces taxes and builds wealth, and is easily integrated into wealth protection and estate planning structures. Up to $1.2 million in taxable income can be shifted from a going concern to a low-tax CIC as deductible insurance premiums.
Warning & Disclaimer: This is not legal or tax advice.
Disclosure of Internal Revenue Service Circular 230: As required by Treasury Department regulations, advice (if any) relating to federal taxes contained in this release is not intended or written for use and may not be used for the purposes of (1) avoiding penalties under the Internal Revenue Code; or (2) promoting, marketing, or recommending to another party any transaction or matter discussed herein.
Copyright 2011 – Thomas Swenson
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